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Interbank lending benchmark Libor needs a large technical overhaul in which banks introduce automated calculations based on real market data, according to experts, in order to avoid the continued risk of market manipulation from bankers’ manual estimates.

A good setup would involve bankers having to submit rates they demonstrably link to real market data, as well as this live trade information being used by banks and rate compilers to automatically survey any suspicious submissions, analysts note.

The comments come after US agency the Federal Deposit Insurance Corporation (FDIC) launched a high profile lawsuit against 16 banks over the alleged fixing and poor management of the rate. Libor underpins approximately $300 trillion of financial contracts, including derivatives, as well as a large proportion of variable rate mortgages.

‘No choice’ but to change

Chris Skinner, chairman at networking group the Financial Services Club, tells Forbes that banks have "no choice" but to change their Libor processes. "The regulators will force banks to automate how they provide data for Libor."

Libor has traditionally been based on estimated rates from banks, rather than hard data. This will have to change, Skinner says, in order for a transparent rate to exist. "What’s important is to take data from the markets, rather than only estimated information informing the Libor rate. But the regulators will have to insist on change, for it to happen."

Ralph Silva, a financial industry analyst at SRN, warns that banks are not taking the issue seriously enough from an operational point of view, and that they still prefer a methodology in which systems and algorithms provide humans with a starting point for manual estimation. The "sentimentality" of the human process "needs to be relegated to the cupboard with typewriters", he says.

City London Skyline (Photo credit: Wikipedia)

The Wheatley Review, by UK regulator the Financial Conduct Authority, concluded that transaction data “should be explicitly used to support Libor submissions”. Guidelines from IOSCO, the association of securities regulators, show a similar standpoint.

But banking industry body the British Bankers’ Association - an organisation being sued by the FDIC over its administration of the rate before it handed over the task to NYSE’s IntercontinentalExchange last month - declined to comment on any changes being made by banks in order to improve Libor submissions.

Technical overhaul ‘completely attainable’

Michael Mainelli, a director at thinktank Z/Yen, says the fact that banks provide estimates without linking them to actual transactions, has played a large part in the problem. But while the correct use of technology can help prevent market manipulation, he warns that banks will resist change.

“Many will see the potential costs and integration timetables, and say there is little incentive, in spite of some of the good work being done by developers and industry experts,” he says. “It’s disappointing, because our industry is one of the easiest to automate, given the fact we already have the data.”

In an article he co-authored with colleague Therese Kieve, called ‘Estimating Libor Damage Past – Automating Index Surveillance Future’, Mainelli writes that early detection, through better surveillance technology, is a good answer.

Libor processes at banks “can and should be automated”, adds Silva at SRN. The process itself would be considered relatively low complexity, because banks already have the algorithms to determine individual positions.

“The work would be in the interconnection of the processes,” Silva says. “It is not trivial, but considering the technical capabilities at the average bank, it is completely attainable.”